Topical Questions Amid a More Political Economy

In this short question and answer session, Nick Maroutsos, Co-Head of Global Bonds, looks at the macroeconomic landscape and how it is shaping his team’s investment decision-making.

Key Takeaways

  • Stresses in the euro region have increased, and we believe it will be difficult for the ECB to avoid further stimulus.
  • Given the increased political uncertainty in the U.S.-China trade dispute, global growth is likely to be subdued until Q2 2020.
  • Bonds are less sensitive than equities to trade and given more accommodative monetary policies, companies should find it easier to refinance. Hence, we expect the credit cycle to be elongated further and defaults to remain contained.
  • We had been more dovish than market consensus in terms of future short-term rates in the U.S., but ultimately, we believe the market will force the Fed into further interest rate cuts.

Is Europe trapped in negative rates? If so, what are the implications for investors?

As interest rates move lower and become more negative, Europe is the epitome of dysfunction. We are five years on from its supposedly temporary shot in the arm for the euro area, and yet the European Central Bank (ECB) still has not achieved its goals and will likely push rates even lower. The ECB is effectively out of ammunition, and we do not believe further stimulus, negative interest rate policy or quantitative easing will help the economy – it will only distort markets further. The bond markets in Europe (particularly Germany) are telling us that the cycle is ending and that the ECB is behind the curve and looking increasingly ineffective.

Stresses in the euro region have increased, particularly with the emergence of an Italian coalition government focused on decreasing taxes and increasing spending with little concern over growing deficits. With Italian risks increasing, we believe it will be difficult for the ECB to avoid further stimulus. We expect 2019 European growth and inflation to continue to be below expectations amid structural rigidities in labor and product markets. We believe investors should focus on identifying better opportunities elsewhere (in regions such as the U.S., Australia, and Asia ex Japan) that not only have the potential to provide higher yields but also better risk-adjusted opportunities. We believe there are a number of opportunities in the UK, but with the overhang of Brexit, a conservative approach is warranted so as to not introduce undue volatility.

Contrasting Yield Curves – U.S. and Germany

Source: Eikon from Refinitiv, U.S. government benchmark yield curve, German government benchmark yield curve, 8/30/2019. M=months, Y=Years

Is the U.S.-China trade dispute a concern for investors?

Political uncertainty has risen rapidly as the U.S. acts with greater unpredictability. This is something that is outside of central bankers’ control, so businesses have less confidence about the environment in which they are operating. We have seen business investment in the UK steadily decline since the Brexit referendum. The U.S. trade disputes are having a similar effect, with evidence that companies globally are foregoing investment until some clarity emerges. This has second-round effects, which, together with weak monetary data, means global growth is likely to be subdued until Q2 2020.

UK business investment (red line) has fallen below that of other advanced G7 economies (gray range) since the EU referendum in 2016

Source: Bank of England Inflation Report, August 2019. Eikon from Refinitiv, Japanese Cabinet Office, OECD, ONS, Oxford Economics, Statistics Canada, U.S. Bureau of Economic Analysis and Bank calculations. G7 business investment: UK business investment, range of G7 countries excluding UK.

Some market observers have likened the U.S.-China dispute to the decade-long U.S.-Japan trade war of the 1980s. While the current trade war could end up taking a while to resolve, both China and the U.S. have far more to lose by not reaching an agreement than Japan and the U.S. had a few decades ago. We are not of the belief that the trade tensions are structural; rather, we feel they are near-term noise.

Bonds, however, are less sensitive than equities to trade and short-term earnings fluctuations. An extended period of low economic growth and low inflation can be a relatively comfortable environment for corporate bonds. The move by central banks toward more accommodative monetary policy should make it easier for companies to refinance, so we would expect the credit cycle to be elongated further and defaults to remain contained.

Is deteriorating creditworthiness a significant risk for 2019?

We believe corporate earnings will hold up better than the market expects, although much relies on global trade. Where we are seeing pressure on creditworthiness is in those areas that are facing structural problems, such as retail, energy and auto components. We are also seeing differences geographically, with leverage (debt divided by earnings before interest, tax, depreciation and amortization) rising in European high yield and U.S. investment grade but declining in U.S. high yield and European investment grade from levels two years ago.

How do you see U.S. Federal Reserve (Fed) policy evolving?

We had been more dovish than market consensus in terms of the future path of short-term rates, but markets are now pricing in multiple cuts by the Fed over the next year. The Fed reduced rates by 0.25% in July 2019 as expected but disappointed markets by telegraphing diminished prospects for additional cuts. Ultimately, we believe the market will force the Fed into further interest rate cuts, although we think talk of zero interest rates in the U.S. in the near term is wide of the mark.

President Trump’s goal is to further his economic agenda, so he will do everything in his power to achieve lower rates and higher equity markets. We see the trade volatility as part of the political stand-off between Washington and the Fed (evidenced by the recent article from Bill Dudley, a former New York Federal Reserve president, who openly suggested the Fed should not enable Trump in his trade war). Market gains are largely driven by central bank expectations, so there is little room for disappointment. We are not sure the Fed has the stomach to disappoint the market, so they will likely cut when the market tells them to do so.

It is unlikely that the Fed will feel the need to embark on any fresh round of quantitative easing, preferring to use lower interest rates to stimulate the economy. This is likely to contrast with Europe, where we see additional quantitative easing taking place.